Clients are increasingly turning to deal-contingent hedging in M&A situations as a cost effective strategy to manage foreign exchange and interest rate risks, according to Selim Toker, Head of the Risk Solutions Group, EMEA.
Over the past 18 months, the world has been surprised by two major political events – Brexit and the election of Donald Trump as US president – which had dramatic repercussions in the financial markets. In the case of Brexit, sterling lost almost 20% of its pre-referendum value in a matter of weeks. The election of Trump, meanwhile, sent bond yields soaring in anticipation of higher interest rates in the future.
These seismic events come at a time of robust merger and acquisition (M&A) volumes. High levels of cash and tough trading conditions in many sectors are prompting companies to seek non-organic growth opportunities. At the same time, private equity-driven M&A volumes are increasing. Turbulent equity market conditions have made initial public offerings (IPOs) a more challenging exit strategy and prompted increased sales of assets to other private equity players or corporates.
Many CFOs or Treasurers might assume that risks relating to M&A transactions from unpredictable events such as Brexit and the US election are difficult to mitigate. However, there are hedging strategies that allow companies and private equity investors involved in a cross-border M&A to mitigate their financial risks cost effectively. They make it possible to lock in the cost of an acquisition in the purchase currency, or to ensure that re-financing costs of the transaction do not increase, and have no costs if the deal does not complete.
A solution for today’s markets
An M&A typically takes around three to twelve months to complete. During that time a lot can change. If the acquirer is a European company or private equity firm and the target a US asset, a transaction will likely be priced in US dollars. If the US dollar appreciates significantly against the euro in the time before completion, the deal will become more expensive, and the internal rate of return (IRR) of the deal lower.
To hedge that risk, a client could simply use an FX forward to lock in its costs. But if the M&A fails – because it is rejected by anti-trust authorities, shareholders or lenders with a change of control clause over the target, for example – the hedge needs to be unwound.
If the FX market has moved against the hedge, the company could incur costs (in addition to the disruption caused by the failure of the M&A itself). For private equity firms, which typically do not have standing funds but rely on their limited partners to fund acquisitions, such costs could prove problematic.
A more effective solution is to hedge the FX risk associated with an M&A on a deal-contingent basis. A deal-contingent hedge combines the best aspects of a standard FX forward and an FX option: it requires no payment upfront and allows the client to lock in a forward rate. A small spread is added to pay for the solution, which is only applied if the M&A is successful and the hedge is used. If the M&A fails, the deal contingent hedge disappears without the client incurring a fee.
Managing refinancing risk
Just as currencies can appreciate during the period it might take an M&A to close, potentially undermining the rationale for an M&A, so financing conditions can also change rapidly. Usually an M&A is initially financed using a bridge loan, which is then replaced by more permanent finance from the bond markets. But if rates rise during this period, the cost of finance is increased and the IRR of the M&A falls.
Deal-contingent interest rate hedging is proving popular because of the growing prospect of US rate rises and increasing bond yields. Even in Europe, where rates are likely to remain low for longer, there is increasing demand for protection as the trajectory of global interest rates becomes clearer.
Possible interest rate solutions include a forward-starting swap, which locks in current rates for an asset or liability on a deal-contingent basis: if the M&A fails there is no cost to the client. Forward-starting swaps are often used for infrastructure transactions, which are typically financed with long-dated debt and are therefore more susceptible to interest rate changes.
Choosing the right partner
Deal-contingent hedging offers a cost effective way to reduce risk and protect against the potentially high costs of FX or interest rates moving against a client. However, while the purpose of a hedge is to transfer risk from the corporate or private equity firm to a bank, it is in the client’s best interest that the bank’s capabilities are robust and it has the necessary experience to ensure the effectiveness and security of the hedge.
To structure a successful deal-contingent hedge, a bank needs a variety of capabilities. Most obviously, a bank must have the risk appetite and balance sheet to provide the hedge. There is no traded market in deal-contingent hedges, so it is unlikely that a bank that structures a deal-contingent hedge for a client can off lay that risk to the market through an equal and opposite hedge.
Effective deal-contingent hedging also requires comprehensive M&A knowledge in order to analyse the purchase agreement and conditions precedent. Often a bank acting as M&A advisor provides a hedge because they are party to the deal and therefore more comfortable with the risk. However, some banks – such as Nomura – have specialist M&A expertise and hedging capabilities and are able offer competitive hedge pricing even when they have no role in the underlying M&A.
In addition, a bank providing a deal-contingent hedge should have deep industry knowledge and coverage in order to understand the dynamics of the sector and the motivations and objectives of both the buyer and seller. Such expertise should also extend to the M&A process itself, enabling the bank to ascertain whether an interloper might emerge during the closing process, for example. Country knowledge is also important to fully assess the risks, such as regulatory risk, relating to a transaction.
On the market side, a bank needs to be able to competitively and consistently price hedges, execute them effectively and quantify and manage the risk associated with them. The bank must be aware of likely drivers of FX movements and interest rates and have effective risk management capabilities, both in relation to the individual hedge and its portfolio of hedges. Necessarily, the marginal risk of a single additional transaction is less in a sizeable, diversified and uncorrelated portfolio, so clients should seek a bank with an established transaction history in order to achieve a competitive price.
Finally, and perhaps most importantly, banks need to be able to coordinate these multiple units across the organisation (as well as their legal division) in order to optimise speed – Nomura is often able to obtain approval for deal-contingent hedges within 48 hours. Among hedge advisors, which are boutique risk advisory businesses engaged by clients to assist with documentation, execution management and bank selection, Nomura is known for its holistic approach and ability to offer a user-friendly service with effective products and processes, and streamlined documentation.
To gain further insight into deal-contingent hedging, please contact Selim Toker.Read more